Is it better to pay off debt or save money? The answer really comes down to your circumstances and your short- and long-term financial goals. Taking some time to really think about your financial situation can help you see if paying down debt, building up emergency savings, or a little bit of both is best for you and your family. This article will cover how and why to build a safety net, how to prioritize paying your debts, and how to create savings goals that will bring you a sense of financial security.
Written by Attorney Eric Hansen.
Updated October 1, 2021
Ah, yes, the age-old question: Is it better to pay off debt or save money? The answer really comes down to your circumstances and your short- and long-term financial goals. Taking some time to really think about your financial situation can help you see if paying down debt, building up emergency savings, or a little bit of both is best for you and your family.
Taking charge of your personal finances and achieving your financial goals isn’t always an easy task. This article will cover how and why to build a safety net, how to prioritize paying your debts, and how to create savings goals that will bring you a sense of financial security.
Build a Safety Net
Having a safety net is critical these days. Many people can’t afford and worry about sudden, unexpected major expenses like car repairs or a hospital visit. Even figuring out how to pay for ordinary household expenses and rent if you lose your job is incredibly stressful. Expect the unexpected. Be prepared.
If you don’t already have an emergency fund, a great first financial goal is to create one. Look around for a money market account with a high interest rate so you can basically get free money with the beauty of compound interest. Your emergency fund should be separate from your 401(k) or IRA retirement account. That’s because it’s tricky to get money from a retirement account on short notice and you may be penalized for making a withdrawal. Plus, you generally don’t want to touch that to pay down debt.
Your goal should be to have 2-3 months’ worth of expenses for a rainy day in your emergency fund. Of course, this means you’ll need to know how much you spend each month on necessities like:
Rent or mortgage
Transportation (car loan payment, gas, insurance)
Debt payoff for student loans, personal loans, or credit cards
Add all this up and multiply it by two or three to see what 2-3 months’ worth of expenses is for you. Even if you can’t save that amount right away, put what you can toward this and continue to build on it. If this is difficult for you, know that you’re not alone. Many Americans can’t afford a sudden $1,000 bill. But if you are deliberate, thoughtful, and diligent, you can take one of the most important steps toward financial stability—having an emergency fund.
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Understand the Terms of Your Debts and Prioritize Which To Pay Off First
Everybody’s financial situation is different. What’s best for you might not be best for someone else. Take hold of your financial situation, make a plan, and set goals. Utilize spreadsheets, financial tools, and other resources to make your own debt payoff plan. Make sure you know everyone you owe money to.
Understanding the different types of debt and what they mean for your financial goals is important. There is secured debt, which is backed up by a piece of property, like a car loan or a mortgage loan. There also is unsecured debt, which is not connected to physical property. This type of debt is riskier for lenders, so it often has higher interest rates. Credit card debt, personal loans, balance transfers, and payday loans are good examples of unsecured debts.
If you get behind in making your debt payments, it can affect your financial situation and your credit score. That’s why it’s important to have a debt payoff plan. There are two easy debt payoff methods you may choose to follow.
Debt Payoff Methods
You want to pay down your debt strategically. This means you’ll need to think about and prioritize which debt to pay off first. Luckily, there are already several debt payoff methods out there. Many financial planners tout the snowball method to pay down debt until you’re debt-free. Another option is the avalanche method. No matter which method you choose, you need to make the minimum payments on all your debts.
Both of these methods are great strategies, and you can also mix and match. The bottom line is that if it’s working for you, great! Keep it up. But if you find yourself falling behind or getting bogged down, reevaluate. The best debt payoff plan is the one you’ll stick with.
In the snowball method, you start by paying off your smallest debt first. You might start by making the minimum payment plus a hundred bucks. Once that’s paid off, move on to your next smallest debt, putting the extra money toward it that you’ve freed up by paying off the first debt. Continue this until all your debts are paid. This is called the snowball method because the amount you can put toward debt repayment each month adds up or snowballs over time. The major advantage of this method is that fully paying off even one debt can help motivate you to continue with your debt payoff and financial goals.
The debt avalanche method is similar, except instead of starting with your debt with the lowest balance, you start with whichever debt has the highest interest rate. You pay that one off as quickly as you are able to by making more than the minimum monthly payment. Once you pay off your highest interest rate debt, you move on to the debt with the next highest interest rate and repeat. This method saves you money over time by helping you avoid costly compound interest, which grows faster on debt with high interest rates. If you can continue to increase your monthly payment, you’ll add to the debt avalanche and pay down your debts more quickly.
Watch Those Interest Rates
Keep in mind that your interest rates may change during your debt repayment process. Monitor your financial situation and reorder your debt payoff targets based on current information. For example, you may have received a promotional interest rate on a balance transfer credit card. Once the promotional period ends, your interest may go from 0% to 22.5% APR. At that point, you want to prioritize that debt accordingly to keep the debt avalanche going.
When you get serious about eliminating your debt, you or your financial advisor should pay close attention to the interest rates and other terms of those accounts. It can be smart to pay off your credit cards with high interest rates first, to avoid paying a lot of extra money on the account over time. But sometimes you want to get a couple of quick victories and some momentum before moving on to bigger debts.
What About Other Debts?
As you focus on higher interest debts, you still need to make minimum payments on all your monthly debt. Pay at least the minimum payment on your car loan, any personal loans, your student loans, your repayment plans, or your mortgage. These loans often have lower interest rates than credit cards. Be careful and don't miss a payment or you risk repossession, a default, or a foreclosure. Also, be sure to read the terms and conditions of your loans and credit card accounts. See if there are prepayment penalties for paying off your loan early. Some mortgage contracts have prepayment penalties if you pay off the loan early.
If you have student loans, consider your repayment options. If you qualify for loan cancellation or loan forgiveness that could be a big help to your financial situation and save you a lot in the long run. Remember to look into your other options for student loans such as deferment, income-based repayment plans, private student loans that offer reduced interest rates, and if need be, forbearance. Keep in mind that it’s entirely possible that many of the coronavirus pandemic rules and student loan grace periods will be rolled back, changed, or discontinued as the economy recovers.
Consider Your Savings Goals
When you have significant debt, you may feel driven to pay it down aggressively. But, you also want to consider your savings goals and your whole financial situation before putting all your money toward debt repayment. Saving money for an emergency fund, a big life event, or retirement in addition to paying down debt is a smart financial move. You can have your cake and eat it too!
Of course, you’ll always want to make your minimum payments. But when you have debts with low interest rates, it might be better to put any extra money you have toward something other than making larger payments each month. When your main debts are car loans and student loans (instead of credit card or payday loans), you may want to save for a life event like a down payment on a house or a college fund. You could also start or increase your contribution to your retirement account. This may also bring your taxable income down. These great money moves will build on your financial plan’s foundation and set you up for future success.
Your retirement or your kids’ college may seem far away, but it is never too early to start saving for those significant life events. Compound interest is an amazing thing. Finding the right long-term savings account is a big step. A licensed and reputable financial advisor can help you develop a retirement plan and fund a retirement account such as an IRA (Individual Retirement Account) in addition to a 401(k) plan your employer may offer. If your employer offers a matching option on your 401(k) plan, take it. That is free money you shouldn’t pass up. Retirement contributions that earn even an average rate of return will be extremely helpful for you, your partner, and your family down the road.
Being debt-free is a really great feeling, but it shouldn’t come at the expense of crushing your other dreams such as owning a home, helping your kids pay for college, or having a comfortable retirement later in life.
To pay off debt or to save? That is the question. Just remember, it doesn’t have to be an either-or situation. You may choose to work toward both, or you may need to just focus on one for a while. It really depends on your financial situation and goals. Money management and healthy finances will look different for different people.
Take some time to think about what’s important for you. Be realistic and thoughtful as you look at your financial situation. Start saving money each month to get a good foundation for an emergency fund. The goal is to have several months’ worth of your monthly household expenses. Then, armed with an understanding of your debts and a solid strategy, pay off your debts while balancing your savings and retirement savings goals.
It can be helpful to work with a credit counselor or financial advisor to come up with a game plan that’s tailored to you and your circumstances. Set financial goals, reassess your financial situation, and make use of the resources available to you.